What Is the Difference Between a Tax Credit and a Tax Deduction?

Q. When talking about taxes, I’ve heard phrases including, “just write it off,” “go ahead and deduct it,” and sometimes “I think there’s a tax credit for that.” My understanding is that both tax deductions and tax credits can save me money on taxes, but I’m unclear on the difference between the two. I saw that your office now does tax returns for clients. Can you enlighten me on how tax credits and tax deductions are different, and strategies for slashing my 2021 tax bill? Thanks for your help!

A. If you’re eager to slash your tax bill, two popular methods are claiming credits and deductions on your return. It is true that both can reduce your balance, but these write-offs have key differences.

Tax Credit vs Tax Deduction

Tax Credits and Tax Deductions are two very different ways to save money on taxes. A tax credit gives you a dollar-for-dollar reduction of the tax you owe, while a tax deduction lowers your taxable income for the year.

Tax Credits: What You Need to Know

As mentioned, tax credits reduce the amount of taxes you owe dollar for dollar. Let’s say that you qualify for a $2,000 tax credit and you owe $3,500 in taxes. The credit would reduce your tax liability by $1,500. Here are the key things you should know about tax credits:

  • Qualifying for a tax credit depends on several factors, including your income, age and tax filing status.
  • A refundable tax credit can help boost your tax refund.
    • The Earned Income Tax Credit (EITC) is a refundable tax credit that helps low- to moderate-income workers and families get a tax break. If you qualify, you can use the credit to reduce the taxes you owe – and maybe increase your refund. For more details about EITC, read this White House Fact Sheet.
  • There are also partially refundable tax credits. With these kinds of tax breaks, part of the credit is refundable and part of it is nonrefundable.
    • The American Opportunity Tax Credit (AOTC) is a partially refundable tax credit that is for qualified education expenses paid for an eligible student for the first four years of higher education. Read more about the AOTC on the IRS website.
  • While claiming tax credits could leave you with a bigger refund, some credits are non-refundable.
    • This means that if the credit reduces your tax liability to a negative number, what’s left over cannot be used to increase the size of your tax refund. For instance, if you have a $1,500 tax credit but you only owe $1,400 in taxes, the extra $100 won’t be included in your refund check.

These are some other common tax credits:

Tax Deductions: What You Need to Know

A tax deduction is a result of a tax-deductible expense or exemption which reduces your taxable income. A common tax deduction on your federal income tax return is the standard deduction. An example of how this works: If your income was $100,000, your standard deduction (if single or married filing separately) would reduce your taxable income by the 2021 standard deduction of $12,500, so your taxable income would now be $87,500. If you are filing jointly, the standard deduction is $25,100 for joint filers this year. If you are 65 or older, the standard deduction for married couples filing jointly is $2,700 more. If your filing status is single and you’re 65 or older, you get an additional $1,700 for your standard deduction.

Tax deductions lower your taxable income for the year. There are two ways to claim deductions. One option is to claim the standard deduction, as described above.

If you don’t want to take the standard deduction, you can itemize your deductions instead. Itemizing involves listing out individual expenses that you want to write off on your return. Itemizing your deductions generally makes the most sense if your total deductible expenses are higher than the standard deduction.

These are some examples of deductible expenses for tax year 2021:

Things to Keep in Mind When Claiming Credits or Deductions

When claiming credits or deductions, you should be aware that your ability to claim certain deductions may be limited depending on your filing status and household income. Another thing to remember is that you can’t claim a credit and a deduction for the same qualified expense. For example, if you paid out-of-pocket to go back to school for a graduate degree, you can’t claim both the tuition and fees deduction and the Lifetime Learning Credit.

When it comes to tax credits and deductions, it’s important to make sure you’re eligible. The chances of an audit are slim, but certain write-offs are more likely to attract scrutiny from the IRS. Experts suggest keeping a copy of tax receipts for seven years to be safe. It’s also wise to get your tax return done by experienced tax preparation professionals, such as those at the Farr Law Firm.

Farr Law Firm is Now Filing Tax Returns for Our Clients

At the Farr Law Firm, we are now offering to prepare tax returns for our clients, including 1040s, 1041 income tax returns for irrevocable grantor trusts (including the grantor trust statement) and 1040s, along with 706 estate tax returns and 709 gift tax returns, as discussed in our recent article on the subject. No-cost initial tax consultations are being offered, so be sure to call the office to schedule your consultation as soon as possible, as appointment slots are limited.

Tax Return Preparation Fairfax: 703-691-1888
Tax Return Preparation Fredericksburg: 540-479-1435
Tax Return Preparation Rockville: 301-519-8041
Tax Return Preparation DC: 202-587-2797

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About Evan H Farr, CELA, CAP

Evan H. Farr is a 4-time Best-Selling author in the field of Elder Law and Estate Planning. In addition to being one of approximately 500 Certified Elder Law Attorneys in the Country, Evan is one of approximately 100 members of the Council of Advanced Practitioners of the National Academy of Elder Law Attorneys and is a Charter Member of the Academy of Special Needs Planners.